The Costs and Benefits of Monopoly

In the topic on 'Market failure', the fact that monopoly is a form of market failure was discussed. It was shown, diagrammatically, that if a market is monopolistic in structure, then the price will tend to be higher and the quantity supplied lower than the totally efficient structure of perfect competition. Let's go over this again, but in the diagrams below, I have assumed that the AC curve, and therefore the MC curve, is horizontal, just to make the diagrammatical analysis easier to follow.

The diagram above is the same as that above for the monopolist's equilibrium output, except the AC curve is horizontal instead of U-shaped. If this market were a monopoly, profits would be maximised where MC = MR (at point E) giving the equilibrium price Pm and quantity Qm. Imagine that this market were perfectly competitive. The equilibrium would now be where the market demand curve (AR) crosses the market supply curve (MC). This occurs at point C, giving the equilibrium price Ppc and quantity Qpc. As expected, the price is higher and the quantity lower if the market is a monopoly.

What is the effect on society? We need to analyses this, in terms of consumer surplus and producer surplus (or profit). Go back to the topic called 'Supply and demand' if you can't remember what these two terms mean.

If this market were perfectly competitive, consumer surplus would be the triangle ACPpc. The is no producer surplus (because AR = AC), so the consumer surplus represents the total benefit to society.

If this market were a monopoly, consumer surplus would be reduced to the triangle ABPm, due to the higher price, but there would be some producer surplus, equal to the rectangle PmBEPpc [producer surplus is the super normal profit, which is total revenue (OPmBQm)minus total cost (OPpcEQm)]. So, total benefit to society under monopolistic conditions is represented by the trapezium ABEPpc. Hence, as a result of this market moving from perfect competition to monopoly,there is a deadweight loss to society, represented by the triangle BCE. This is effectively the loss to consumers as a result of being denied the chance to purchase output QmQpc at prices between Ppc and Pm. Also, some would argue that the producer surplus, which was once consumer surplus, was better off in the hands of the consumers, rather than a few 'fat cat' monopolist managers.

So, monopoly is bad. Or is it? The following diagram shows a situation where market structure of monopoly might be better for society than perfect competition.

In the diagram above, monopoly is seen to be hugely beneficial to society. And why is this? Our initial analysis overlooked the fact that large firms usually benefit significantly from economies of scale. This shifts the AC curve downwards. If this shift is very large, as is assumed in the diagram above, then a monopolist may charge a lower price and produce a higher output than if the market were perfectly competitive. The monopolist maximises its profits. MC = MR occurs at point E, giving price Pm and quantity Qm. This means that consumer surplus increases from ABPpc to ACPm, and then, of course, there is the large producer surplus, the rectangle CEFPm. The total gain to society is the area BCEFPpc.

The final diagram shows the more realistic comparison. Society is likely to gain to some extent from the monopolist's economies of scale, but it will also lose out, as the monopolist will probably still set a higher price than if the market were perfectly competitive.

Hopefully by now you understand why the prices and quantities are where they are. The key point here is that society gains due to the economies of scale (area EFGPpc), but there is a loss due to the higher price and lower quantity (triangle BCE). So, we can write Overall Gain = EFGPpc − BCE. The relative sizes of these areas will depend on the extent to which the monopolist can benefit from economies of scale. The bigger the drop in the AC = MC line, the larger the green box will be and the smaller the red triangle will be.

The benefit to society (the green box) is, in fact, just a benefit to the monopolist, whereas the loss to society (the red triangle) is a loss to the consumers. Which group in society is more important?

Moving away from the diagrams, there is another issue: innovation. Some argue that a monopolist can afford to spend huge amounts (often fruitlessly) on research and development. They are more likely, therefore, to create new, and better, products. Others would argue that due to the lack of competition that the monopolist faces, it relaxes, seeing no need to be innovative, whereas firms in a more competitive environment have the incentive to innovate to get ahead of the pack.